##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



FOR THE TRANSITION PERIOD FROM  TO
.



COMMISSION FILE NO. 000-31519



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CURON MEDICAL, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 77-0470324                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



46117 Landing
Parkway

Fremont, CA 94538

(Address of principal executive offices, including zip code)



(510) 661-1800

(Registrants telephone number, including area code)



---



Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).    Yes ̈No  x



Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act.):    Yes ̈No  x



As of November 4, 2005,
43,349,465 shares of the Registrants Common Stock were outstanding.



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##### Table of Contents

CURON MEDICAL, INC.

INDEX



|           |  |                       |  |                                                                                                                        |  |   
|---------- |  | --------------------- |  | ---------------------------------------------------------------------------------------------------------------------- |  | --
|           |  | Page                 
|PART I.    |  | FINANCIAL INFORMATION |  |                                                                                                                       
|           |  |                       | 
|           |  | Item 1.               |  | Financial Statements (unaudited)                                                                                       |  |   
|           |  |                       | 
|           |  |                       |  | Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004                                   |  | 3 
|           |  |                       | 
|           |  |                       |  | Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2005 and 2004 |  | 4 
|           |  |                       | 
|           |  |                       |  | Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2005 and 2004           |  | 5 
|           |  |                       | 
|           |  |                       |  | Notes to Condensed Consolidated Financial Statements                                                                   |  | 6 
|           |  |                       | 
|           |  | Item 2.               |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                  |  | 10
|           |  |                       | 
|           |  | Item 3.               |  | Quantitative and Qualitative Disclosures of Market Risk                                                                |  | 21
|           |  |                       | 
|           |  | Item 4.               |  | Controls and Procedures                                                                                                |  | 22
|           |  |                      
|PART II.   |  | OTHER INFORMATION     |  |                                                                                                                       
|           |  |                       | 
|           |  | Item 1.               |  | Legal Proceedings                                                                                                      |  | 22
|           |  |                       | 
|           |  | Item 6.               |  | Exhibits                                                                                                               |  | 22
|           | 
|SIGNATURES |  | 23                   



2



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##### Table of Contents

PART I FINANCIAL INFORMATION



Item 1. Financial Statements



CURON MEDICAL, INC.

Condensed Consolidated Balance Sheets

(Unaudited, in thousands)



|                                           |  |                    |          |   |                   |   |         |  
|------------------------------------------ |  | ------------------ | -------- | - | ----------------- | - | ------- | -
|                                           |  | September 30, 2005 |          |   | December 31, 2004 |  
|Assets                                     |  |                    |          |   |                   |   |         |  
|Current assets:                            |  |                    |          |   |                   |   |         |  
|Cash and cash equivalents                  |  | $                  | 1,912    |   |                   | $ | 374     |  
|Marketable securities                      |  |                    | 4,595    |   |                   |   | 5,518   |  
|Accounts receivable, net                   |  |                    | 488      |   |                   |   | 620     |  
|Inventories, net                           |  |                    | 1,304    |   |                   |   | 777     |  
|Prepaid expenses and other current assets  |  |                    | 843      |   |                   |   | 987     |  
|                                           |  |                    |          |   |                   |   |         |  
|Total current assets                       |  |                    | 9,142    |   |                   |   | 8,276   |  
|                                           |  |                   
|Property and equipment, net                |  |                    | 388      |   |                   |   | 551     |  
|Other assets                               |  |                    | 300      |   |                   |   | 330     |  
|                                           |  |                    |          |   |                   |   |         |  
|Total assets                               |  | $                  | 9,830    |   |                   | $ | 9,157   |  
|                                           |  |                    |          |   |                   |   |         |  
|Liabilities and Stockholders Equity       |  |                    |          |   |                   |   |         |  
|Current liabilities:                       |  |                    |          |   |                   |   |         |  
|Accounts payable                           |  | $                  | 355      |   |                   | $ | 473     |  
|Accrued liabilities                        |  |                    | 1,000    |   |                   |   | 1,121   |  
|Notes payable                              |  |                    | 255      |   |                   |   | 57      |  
|                                           |  |                    |          |   |                   |   |         |  
|Total current liabilities                  |  |                    | 1,610    |   |                   |   | 1,651   |  
|                                           |  |                   
|Warrant obligation                         |  |                    | 2,383    |   |                   |   | 469     |  
|Other                                      |  |                    | 85       |   |                   |   | 124     |  
|                                           |  |                    |          |   |                   |   |         |  
|Total liabilities                          |  |                    | 4,078    |   |                   |   | 2,244   |  
|                                           |  |                    |          |   |                   |   |         |  
|Contingencies and commitments (Note 5)     |  |                    |          |   |                   |   |         |  
|                                           |  |                   
|Stockholders equity:                      |  |                    |          |   |                   |   |         |  
|Common stock                               |  |                    | 43       |   |                   |   | 25      |  
|Additional paid-in capital                 |  |                    | 107,982  |   |                   |   | 101,739 |  
|Accumulated deficit                        |  |                    | (102,036 | ) |                   |   | (94,607 | )
|Treasury stock                             |  |                    | (234     | ) |                   |   | (234    | )
|Accumulated other comprehensive loss       |  |                    | (3       | ) |                   |   | (10     | )
|                                           |  |                    |          |   |                   |   |         |  
|Total stockholders equity                 |  |                    | 5,752    |   |                   |   | 6,913   |  
|                                           |  |                    |          |   |                   |   |         |  
|Total liabilities and stockholders equity |  | $                  | 9,830    |   |                   | $ | 9,157   |  
|                                           |  |                    |          |   |                   |   |         |  



See accompanying notes
to condensed consolidated financial statements



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##### Table of Contents

CURON MEDICAL, INC.

Condensed Consolidated Statements of Operations

(Unaudited)

(in thousands, except per share
amounts)



|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------- |  | ---------------------------------------- | ------ | - | --------------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                               |  | For the Three Months Ended September 30, |        |   | For the Nine Months Ended September 30, |  
|                                                               |  | 2005                                     |        |   | 2004                                    |   |        | 2005 |  |   | 2004    |  
|Revenues                                                       |  | $                                        | 745    |   |                                         | $ | 862    |      |  | $ | 2,754   |   |  | $ | 2,699   |  
|Cost of goods sold                                             |  |                                          | 842    |   |                                         |   | 1,036  |      |  |   | 2,837   |   |  |   | 3,168   |  
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Gross loss                                                     |  |                                          | (97    | ) |                                         |   | (174   | )    |  |   | (83     | ) |  |   | (469    | )
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Operating expenses:                                            |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Research and development                                       |  |                                          | 312    |   |                                         |   | 430    |      |  |   | 906     |   |  |   | 1,360   |  
|Clinical and regulatory                                        |  |                                          | 212    |   |                                         |   | 222    |      |  |   | 732     |   |  |   | 857     |  
|Sales and marketing                                            |  |                                          | 1,608  |   |                                         |   | 1,836  |      |  |   | 5,902   |   |  |   | 5,914   |  
|General and administrative                                     |  |                                          | 898    |   |                                         |   | 2,009  |      |  |   | 2,766   |   |  |   | 4,022   |  
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                       |  |                                          | 3,030  |   |                                         |   | 4,497  |      |  |   | 10,306  |   |  |   | 12,153  |  
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Operating loss                                                 |  |                                          | (3,127 | ) |                                         |   | (4,671 | )    |  |   | (10,389 | ) |  |   | (12,622 | )
|                                                               |  |                                          |        |  
|Interest income                                                |  |                                          | 63     |   |                                         |   | 31     |      |  |   | 112     |   |  |   | 112     |  
|Decrease in warrant obligation                                 |  |                                          | 2,351  |   |                                         |   | 297    |      |  |   | 2,842   |   |  |   | 1,419   |  
|Other income (expense), net                                    |  |                                          | (3     | ) |                                         |   | (5     | )    |  |   | 7       |   |  |   | (20     | )
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                       |  | $                                        | (716   | ) |                                         | $ | (4,348 | )    |  | $ | (7,428  | ) |  | $ | (11,111 | )
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share, basic and diluted                          |  | $                                        | (0.02  | ) |                                         | $ | (0.18  | )    |  | $ | (0.22   | ) |  | $ | (0.47   | )
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  
|Shares used in computing net loss per share, basic and diluted |  |                                          | 43,349 |   |                                         |   | 24,470 |      |  |   | 34,010  |   |  |   | 23,840  |  
|                                                               |  |                                          |        |   |                                         |   |        |      |  |   |         |   |  |   |         |  



See accompanying notes
to condensed consolidated financial statements



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##### Table of Contents

CURON MEDICAL, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited, in thousands)



|                                                                            |  |                                          |         |   |      |   |         |  
|--------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                            |  | For the Nine Months Ended, September 30, |        
|                                                                            |  | 2005                                     |         |   | 2004 |  
|Cash Flows From Operating Activities                                        |  |                                          |         |   |      |   |         |  
|Net loss                                                                    |  | $                                        | (7,428  | ) |      | $ | (11,111 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                          |         |   |      |   |         |  
|Depreciation and amortization                                               |  |                                          | 218     |   |      |   | 362     |  
|Stock-based compensation                                                    |  |                                          | (22     | ) |      |   | 15      |  
|Loss on disposal of fixed assets                                            |  |                                          |        |   |      |   | 8       |  
|Decrease in warrant obligation                                              |  |                                          | (2,842  | ) |      |   | (1,419  | )
|Amortization of premium on securities                                       |  |                                          | 38      |   |      |   | 406     |  
|Changes in assets and liabilities:                                          |  |                                          |         |   |      |   |         |  
|Accounts receivable, net                                                    |  |                                          | 132     |   |      |   | 342     |  
|Inventories, net                                                            |  |                                          | (527    | ) |      |   | (67     | )
|Prepaid expenses and other current assets                                   |  |                                          | 144     |   |      |   | (23     | )
|Other assets                                                                |  |                                          | 30      |   |      |   |        |  
|Accounts payable                                                            |  |                                          | (118    | ) |      |   | (6      | )
|Accrued liabilities                                                         |  |                                          | (121    | ) |      |   | 209     |  
|Decrease in settlement of legal liabilities                                 |  |                                          |        |   |      |   | (1,250  | )
|Other long-term assets and liabilities                                      |  |                                          | (38     | ) |      |   | 18      |  
|                                                                            |  |                                          |         |   |      |   |         |  
|Net cash used in operating activities                                       |  |                                          | (10,534 | ) |      |   | (12,516 | )
|                                                                            |  |                                          |         |   |      |   |         |  
|Cash Flows From Investing Activities                                        |  |                                          |         |   |      |   |         |  
|Purchase of property and equipment                                          |  |                                          | (55     | ) |      |   | (406    | )
|Purchase of marketable securities                                           |  |                                          | (4,608  | ) |      |   | (11,960 | )
|Proceeds from maturities of marketable securities                           |  |                                          | 5,500   |   |      |   | 9,200   |  
|                                                                            |  |                                          |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                         |  |                                          | 837     |   |      |   | (3,166  | )
|                                                                            |  |                                          |         |   |      |   |         |  
|Cash Flows From Financing Activities                                        |  |                                          |         |   |      |   |         |  
|Proceeds from issuance of common stock and warrants, net of issuance costs  |  |                                          | 10,955  |   |      |   | 12,627  |  
|Exercise of stock options and ESPP                                          |  |                                          | 82      |   |      |   | 236     |  
|Proceeds from issuance of notes payable                                     |  |                                          | 675     |   |      |   | 649     |  
|Principal payments on notes payable                                         |  |                                          | (477    | ) |      |   | (421    | )
|                                                                            |  |                                          |         |   |      |   |         |  
|Net cash provided by financing activities                                   |  |                                          | 11,235  |   |      |   | 13,091  |  
|                                                                            |  |                                          |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                        |  |                                          | 1,538   |   |      |   | (2,591  | )
|Cash and cash equivalents at beginning of period                            |  |                                          | 374     |   |      |   | 4,865   |  
|                                                                            |  |                                          |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                  |  | $                                        | 1,912   |   |      | $ | 2,274   |  
|                                                                            |  |                                          |         |   |      |   |         |  



See accompanying notes
to the condensed consolidated financial statements



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##### Table of Contents

CURON MEDICAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited, tabular amounts in thousands, except per share amounts)



NOTE 1. The Company and Summary of Significant Accounting Policies



The Company



Curon Medical, Inc. (the Company) was incorporated in the State of Delaware in May 1997 as Conway-Stuart Medical Inc. and changed its name to Curon Medical
Inc., in March 2000. The Company develops, manufactures and markets proprietary products for the treatment of gastrointestinal disorders.



The Company has sustained operating losses and negative cash flows from operations and expects such losses to continue in the foreseeable future. The Company has been
financing its operations primarily through its cash and cash equivalents, revenues, marketable securities, and financing activities. The Company intends to finance its operations primarily through its cash and cash equivalents, marketable
securities, future financing and future revenues. Based on its current expectations of sales and operating costs, the Company anticipates that it will be unable to maintain its currently planned operations through 2006. If future revenues are less
than expected or if operating costs are greater than expected the Company will consume its capital resources significantly sooner than it expects. The Company is pursuing a number of alternatives to maximize stockholder value, including strategic
transactions, collaborative partnerships and the licensing or sale of certain of its intellectual property. Licensing or collaborative arrangements, if necessary to raise additional funds, may require the Company to relinquish rights to certain or
all of its products or technologies. Any additional financing may not be available in amounts or on terms acceptable to the Company, if at all. If the Company is unable to raise additional financial resources, the Company may be unable to continue
as a going concern.



The accompanying condensed consolidated financial
statements have been prepared on a going concern basis which contemplates continuity of operations, realization of assets, and liquidation of liabilities in the ordinary course of business, and do not reflect adjustments that might result if the
Company were not to continue as a going concern.



Basis of Presentation



The condensed consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries after elimination of all intercompany balances and transactions. The Company operates in one reportable segment.



The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in
the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the Securities and Exchange Commission (SEC). Accordingly, they do not include
all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual
consolidated financial statements and, in the opinion of management, contain all adjustments (all of which are normal and recurring in nature) necessary to state fairly the financial position, results of operations and cash flows of the Company for
the periods indicated. Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods.



These condensed consolidated financial statements should be read in conjunction with the audited financial statements included in the Annual
Report on Form 10-K for the year ended December 31, 2004, as filed with the SEC.



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##### Table of Contents

Net Loss Per Share



Basic and diluted net loss per share is calculated as follows:



|                                     |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|------------------------------------ |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                     |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |  
|                                     |  | 2005                             |        |   | 2004                            |   |        | 2005 |  |   | 2004   |  
|Net loss (numerator):                |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net loss                             |  | $                                | (716   | ) |                                 | $ | (4,348 | )    |  | $ | (7,428 | ) |  | $ | (11,111 | )
|                                     |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Shares (denominator):                |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Weighted average shares outstanding  |  |                                  | 43,349 |   |                                 |   | 24,470 |      |  |   | 34,010 |   |  |   | 23,840  |  
|                                     |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net loss per share-basic and diluted |  | $                                | (0.02  | ) |                                 | $ | (0.18  | )    |  | $ | (0.22  | ) |  | $ | (0.47   | )
|                                     |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |         |  



The following shares issuable through
the Companys Employee Stock Purchase Plan (ESPP), outstanding options, and warrants were excluded from the computation of diluted net loss per share as they all had an anti-dilutive effect:



|                                               |  |               |  |      
|---------------------------------------------- |  | ------------- |  | -----
|                                               |  | September 30,
|                                               |  | 2005          |  | 2004 
|Shares issuable through ESPP                   |  | 10            |  | 59   
|Shares issuable upon exercise of stock options |  | 4,343         |  | 3,634
|Shares issuable upon exercise of warrants      |  | 11,453        |  | 1,475
|                                               |  |               |  |      
|Total                                          |  | 15,806        |  | 5,168
|                                               |  |               |  |      



Stock-Based Compensation



The Company accounts for stock-based employee compensation arrangements
in accordance with provisions of Accounting Principles Board Opinion, APB, No. 25, Accounting for Stock Issued to Employees and complies with the disclosure provisions of Statement of Financial Accounting Standards, SFAS,
No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure. Under APB No. 25, unearned stock compensation is based on the
difference, if any, on the date of grant, between the fair value of the Companys common stock and the exercise price. Had the Company determined its stock-based compensation based on the fair value at the grant dates for the awards under a
method prescribed by SFAS No. 123, the Companys net loss would have been increased to the FAS 123 adjusted amounts indicated below, as amended by SFAS No. 148:



|                                                                                                          |  |                                  |       |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ----- | - | ------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                                                                          |  | Three Months Ended September 30, |       |   | Nine Months Ended September 30, |  
|                                                                                                          |  | 2005                             |       |   | 2004                            |   |        | 2005 |  |   | 2004   |  
|Net loss, as reported                                                                                     |  | $                                | (716  | ) |                                 | $ | (4,348 | )    |  | $ | (7,428 | ) |  | $ | (11,111 | )
|Add: Stock-based employee compensation expense in reported net income                                     |  |                                  |      |   |                                 |   |       |      |  |   |       |   |  |   | 4       |  
|Deduct : Total stock-based employee compensation expense determined under fair value based for all awards |  |                                  | (203  | ) |                                 |   | (166   | )    |  |   | (614   | ) |  |   | (488    | )
|                                                                                                          |  |                                  |       |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net loss - FAS 123 adjusted                                                                               |  | $                                | (919  | ) |                                 | $ | (4,514 | )    |  | $ | (8,042 | ) |  | $ | (11,595 | )
|                                                                                                          |  |                                  |       |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net loss per share - as reported basic and diluted                                                        |  | $                                | (0.02 | ) |                                 | $ | (0.18  | )    |  | $ | (0.22  | ) |  | $ | (0.47   | )
|                                                                                                          |  |                                  |       |   |                                 |   |        |      |  |   |        |   |  |   |         |  
|Net loss per share - FAS 123 adjusted basic and diluted                                                   |  | $                                | (0.02 | ) |                                 | $ | (0.18  | )    |  | $ | (0.24  | ) |  | $ | (0.49   | )
|                                                                                                          |  |                                  |       |   |                                 |   |        |      |  |   |        |   |  |   |         |  



The Company accounts for equity
instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services. The equity instruments are valued using the Black-Scholes model. All unvested shares are marked to market until such options vest.



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##### Table of Contents

Product Warranty



The Company generally warrants its capital equipment products against defects for a period of one year and records a liability for such product warranty obligations at
the time of sale based upon historical experience. The Company also sells separately priced extended warranties to provide additional warranty coverage and recognizes the related revenue on a straight-line basis over the extended warranty period,
which is generally one to four years. Costs associated with services performed under the extended warranty obligation are expensed as incurred.



Changes in product warranty obligations, including separately priced extended warranty obligations, for the nine months ended September 30, 2005 and 2004 are as
follows:



|                                                                         |  |                                         |    |   |      |   |    |  
|------------------------------------------------------------------------ |  | --------------------------------------- | -- | - | ---- | - | -- | -
|                                                                         |  | For the Nine Months Ended September 30, |   
|                                                                         |  | 2005                                    |    |   | 2004 |  
|Balance as of the beginning of the period                                |  | $                                       | 83 |   |      | $ | 58 |  
|Add: Accruals for warranties issued                                      |  |                                         | 19 |   |      |   | 31 |  
|Less: Settlements made                                                   |  |                                         | (5 | ) |      |   | (1 | )
|Revenue recognized under separately priced extended warranty obligations |  |                                         | (6 | ) |      |   | (9 | )
|                                                                         |  |                                         |    |   |      |   |    |  
|Balance as of the end of the period                                      |  | $                                       | 91 |   |      | $ | 79 |  
|                                                                         |  |                                         |    |   |      |   |    |  



NOTE 2. Issuance of Common Stock
and Warrants



On April 8 and June 3, 2005, the Company completed
the private placement of common stock and warrants with a group of institutional investors and raised approximately $12.0 million in gross proceeds. Net proceeds after offering costs and expenses were approximately $11.0 million. The Company paid to
the parties that acted as its agents in connection with this private placement fees of $859,000 in cash and issued warrants to purchase 553,352 shares of its common stock as additional consideration. The terms of these warrants are identical to
those issued to the investors. The transaction was completed in two closings, and involved the sale of an aggregate of 18,445,078 newly issued shares of the Companys common stock at a price of $0.65 per share and warrants to purchase an
aggregate of 9,222,539 shares of common stock with an exercise price of $1.00 per share. In the first closing, the Company issued 4,962,614 shares of common stock and warrants to purchase 2,481,298 shares of common stock, for gross proceeds to the
Company of approximately $3.2 million. The aggregate fair value of the warrants on the date of issuance was approximately $1.4 million. In the second closing, the Company issued 13,482,464 shares of common stock and warrants to purchase
6,741,241 shares of common stock, for gross proceeds to the Company of approximately $8.8 million. The aggregate fair value of the warrants on the date of issuance was approximately $3.3 million. The common stock warrants have a five-year term
and become exercisable on October 8, 2005 and December 3, 2005, respectively. In addition, as detailed in the common stock purchase warrant agreement, the warrants include a provision whereby the Company could be required to repurchase
these warrants upon the occurrence of certain Fundamental Transactions defined in the agreement. If the Fundamental Transaction is consummated by the Company after the second anniversary of the issuance of the warrants and the
consideration received by the warrant holder is less than 30% in excess of the warrants exercise price, the Company (or the Companys successor) must purchase the warrant from a holder. The purchase price of the warrant will be equal to
the Black-Scholes value of the unexercised portion of the warrant as of the date the request to purchase is made. As a result, the aggregate fair value of the warrants of $1.4 and $3.3 million was recorded as a liability with the remaining net
proceeds of $6.3 million recorded as equity in the accompanying condensed consolidated balance sheet. The warrants were valued on April 8, and June 3, 2005 using the Black-Scholes model with the following assumptions: 5 year expected life,
risk free interest rate of 4.08% and 3.72%, respectively, dividend yield of zero and a volatility of 100%.



In accordance with the warrant purchase agreement and following the first closing of financing, the Company notified holders of common stock warrants issued in February 2004 that the exercise price of the warrants
decreased from $4.71 to $3.85 and the number of common stock shares to purchase upon exercise of warrants increased from 905,625 to 1,107,920, so that the aggregate exercise price of $4,265,494 remains unchanged.



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##### Table of Contents

NOTE 3. Inventories



|                |  |                   |       |                   |   |    
|--------------- |  | ----------------- | ----- | ----------------- | - | ---
|                |  | September 30,2005 |       | December 31, 2004
|Inventories:    |  |                   |       |                   |   |    
|Raw materials   |  | $                 | 720   |                   | $ | 563
|Work-in-process |  |                   | 60    |                   |   | 13 
|Finished goods  |  |                   | 524   |                   |   | 201
|                |  |                   |       |                   |   |    
|                |  | $                 | 1,304 |                   | $ | 777
|                |  |                   |       |                   |   |    



NOTE 4. Non-Employee Stock
Compensation



Stock-based compensation (benefit) expense included in the
Condensed Consolidated Statements of Operations is as follows:



|                         |  |                                  |    |   |                                 |   |     |      |  |   |      |   |  |   |   
|------------------------ |  | -------------------------------- | -- | - | ------------------------------- | - | --- | ---- |  | - | ---- | - |  | - | --
|                         |  | Three Months Ended September 30, |    |   | Nine Months Ended September 30,
|                         |  | 2005                             |    |   | 2004                            |   |     | 2005 |  |   | 2004
|Research and development |  | $                                |   |   |                                 | $ |    |      |  | $ |     |   |  | $ | 1 
|Clinical and regulatory  |  |                                  | (5 | ) |                                 |   | (8  | )    |  |   | (18  | ) |  |   | 9 
|Sales and marketing      |  |                                  | (1 | ) |                                 |   | (3  | )    |  |   | (4   | ) |  |   | 5 
|                         |  |                                  |    |   |                                 |   |     |      |  |   |      |   |  |   |   
|                         |  | $                                | (6 | ) |                                 | $ | (11 | )    |  | $ | (22  | ) |  | $ | 15
|                         |  |                                  |    |   |                                 |   |     |      |  |   |      |   |  |   |   



NOTE 5. Contingencies



The Company is involved in routine legal and administrative proceedings
that arise from the normal conduct of business. Management believes that the ultimate disposition of these matters will not have a material adverse effect on the financial results or condition of the Company.



In April 2003, a civil action was filed against the Company in United States District Court
for the Northern District of California by Federal Insurance Corporation, the Companys insurance carrier, for rescission, reformation, and restitution in connection with the Companys liability insurance policy. The Company settled this
litigation during the quarter ended September 30, 2005 for approximately $50,000, a partial return to the Company of its insurance premiums.



NOTE 6. Subsequent Events



On October 31, 2005, the Company entered into a Contract Manufacturing Agreement with Life Science Outsourcing, Inc. No material relationship existed between the
Company or its affiliates and Life Science Outsourcing prior to the execution of the Agreement. Pursuant to the Agreement, the Company will be outsourcing the manufacturing of its disposable products. Future payments to be made by the Company to
Life Science Outsourcing will depend on the number of orders placed by the Company. The Agreement has a term of one year and will be renewed on an annual basis unless otherwise mutually agreed by both parties.



In connection with the execution of the Contract Manufacturing Agreement to outsource the
manufacturing of its disposable products, the Company announced an initiative to reduce employee headcount on November 1, 2005. Under that initiative, the Company anticipates reducing its employee headcount by 38 during fourth quarter of fiscal
2005, which would bring its headcount from 71 to 33 employees.



The Company
estimates that total expenses to be incurred in connection with the initiative will be approximately $475,000 to $500,000. These expenses include approximately $215,000 for severance and approximately $260,000 to $285,000 for transition costs of the
manufacturing from Fremont, California to Brea, California including freight, calibration costs, regulatory costs, pilot lots and training and travel associated therewith. Most of these expenses will be incurred in the fourth quarter of 2005 with
between $25,000 and $35,000 in the first quarter of 2006.



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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations



The following discussion should be read in conjunction with the attached financial statements and notes thereto, and with our annual financial statements and notes
thereto for the fiscal year ended December 31, 2004.



This quarterly
report, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include statements relating to our expectations as to the rates of market
adoption of our products, the timing and effect on market adoption of reimbursement approvals, the timing and extent of technical improvements to our products, and our ability to achieve higher sales volume for this fiscal year. These
forward-looking statements involve risks and uncertainties. The cautionary statements set forth below and those contained in Factors That May Affect Future Results, commencing on page 14, identify important factors that could cause
actual results to differ materially from those predicted in any such forward-looking statements.



Overview



Company Profile



We were incorporated in Delaware in May 1997 as Conway-Stuart Medical
Inc. and changed our name to Curon Medical Inc., in March 2000. We develop, manufacture and market innovative proprietary products for the treatment of gastrointestinal disorders. Our products consist of radiofrequency generators and single-use
disposable devices.



Our first product, the Stretta® System, received
United States Food and Drug Administration FDA, clearance in April 2000 for the treatment of gastroesophageal reflux disease, or GERD, which affects approximately 19 million U.S. adults on a daily basis. In patients with GERD,
stomach contents reflux backward from the stomach into the esophagus, causing a wide range of symptoms and complications, including, most commonly, persistent heartburn and chest pain. Unlike medication, which addresses GERD symptoms, our Stretta
System applies radiofrequency energy to treat the causes of GERD. The Stretta System consists of a disposable catheter with needle electrodes and our control module, which is a radiofrequency energy generator. Using the Stretta System, the physician
delivers temperature-controlled radiofrequency energy to the muscle of the lower esophageal sphincter and upper portion of the stomach. The delivery of this energy creates heat, causing tissue contraction and creating thermal lesions that resorb
over time, resulting in improved sphincter function. Clinical studies show a significant reduction in GERD symptom scores, esophageal acid exposure, and use of anti-secretory medications.



We commercially launched the Stretta System in May 2000. As of September 30, 2005, we have sold over 350 control modules and
approximately 9,000 patients have been treated with the Stretta Procedure.



Our
second product, the Secca® System , is a radiofrequency energy-based system for the treatment of bowel incontinence (referred to as Fecal incontinence). Bowel incontinence is caused by damage to the anal sphincter due to childbirth,
surgery, neurological disease, injury or age, and affects up to 16 million adults in the United States. Using the Secca System, physicians deliver radiofrequency energy to the anal sphincter muscle in the anal canal. Clinical studies have shown
a reduction in bowel incontinence symptoms and improvement in general quality of life. In March 2002, we received 510(k) clearance from the FDA to market the Secca System for the treatment of fecal incontinence in patients who have failed more
conservative therapies such as diet modification and biofeedback. We undertook a limited test launch of Secca in June 2002, and fully launched the product commercially in May 2003.



We have a direct sales force to market and sell our products in the United States. We market the Stretta System, as an alternative to
anti-reflux surgery, primarily to general surgeons and gastroenterologists. In the United States, we estimate that there are approximately 4,500 general surgeons and 7,000 gastroenterologists who actively perform endoscopy. We market the Secca
System primarily to colon and rectal surgeons and to those general surgeons who perform colorectal surgery. We estimate that there are approximately 1,200 colon and rectal surgeons and up to 3,000 general surgeons that routinely perform colorectal
surgery in the United States.



Our Stretta System has also received European,
Australian and Canadian regulatory approval, and our Secca System has also received regulatory approval in Europe. We incorporated a subsidiary company in Belgium in November 2000 to manage distribution of our products in Europe, the Middle East and
Africa. We have entered into international distribution agreements in the following countries presented in alphabetical order, all of which cover the sale of both Stretta and Secca products: Austria, Belgium, Brazil, China (PRC), China (Republic
of), China (Hong Kong), Costa Rica, Denmark, Egypt, Finland, France, Germany, India, Indonesia, Ireland, Israel, Italy, Malaysia, The Netherlands, Norway, Philippines, Portugal, Singapore, South Africa, South Korea, Spain, Sweden, Switzerland,
Thailand, Turkey, United Arab Emirates, United Kingdom, Viet Nam, Some agreements cover more than one country. From time to



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time national distributors are replaced or terminated and there may be times when we may have no representation in one or
more of the above countries. Regulatory controls in certain countries prevent sales being made until the distributor completes the approval process. We are organized into a single reportable segment consisting of the development, manufacture, and
marketing of proprietary products for the treatment of gastrointestinal disorders. We use one measurement of profitability and do not disaggregate our business for internal reporting.



The American Medical Association issued a Category I CPT code for the Stretta procedure that became effective January 1, 2005, which
will make it easier for physicians to code for the procedure. CPT codes are used to specify the physician component of the procedure cost.



Trends



We believe that the slow adoption of our products has been accounted for specifically by the lack of economic benefit to physician users caused by unfavorable reimbursement rates and coverage and the lack of patient
pressure on physicians due to lack of patient knowledge of the availability of both procedures. We believe this is largely caused by our lack of resources devoted to direct-to-patient advertising. The outsourcing of the assembly of our disposables
is intended to reduce our cost of product by eliminating production overhead. Although by doing this, we lose potential cost advantages if sales start to grow significantly, outsourcing now will reduce our cost structure and our cash burn. We
believe that if we can maintain sales at the average of just over $1 million per quarter our net cash burn can be materially reduced.



RESULTS OF OPERATIONS



Periods of three and nine months ended September 30, 2005 and 2004.



Revenues



Our revenues are comprised of sales of our Stretta and Secca generators and disposable devices. Revenues for the quarter ended September 30, 2005 were $745,000, compared to $862,000 for the same quarter in 2004.
The decrease compared to 2004 was due primarily to a decrease in sales of our Stretta System products of $81,000 and Secca System products of $29,000. Stretta System products accounted for $444,000, or 61%, and Secca System products accounted for
$287,000, or 39%, of the quarters revenues. In the third quarter of 2004, Stretta System products accounted for $525,000, or 62%, and Secca System products were $316,000, or 38%, of the quarters revenues. The Stretta Control Modules and
Catheters accounted for $191,000, or 43%, and $231,000, or 52%, respectively, of the Stretta System product sales for the quarter ended September 30, 2005, compared to $154,000, or 29%, and $346,000, or 66%, respectively, for the same period in
2004. The Secca Control Modules and Handpieces accounted for $101,000, or 35%, and $173,000, or 60%, respectively, of the Secca System product sales for the quarter ended September 30, 2005, compared to $131,000, or 42%, and $169,000, or 53%,
respectively, for the same period in 2004. International sales accounted for $143,000 in the quarter ended September 30, 2005, compared to $28,000 in the same quarter of 2004.



Revenues for the nine months ended September 30, 2005 were $2,754,000, compared to $2,699,000 for the same period in 2004. The increase
compared to 2004 was due primarily to increased sales of Secca system products of $682,000, partially offset by a decline in Stretta System products of $618,000. Stretta System products accounted for $1,505,000, or 56%, and Secca System products
$1,196,000, or 44% of the revenues for the nine months ended September 30, 2005, as compared to $2,123,000, or 81% and $514,000, or 19%, respectively, for the same period in 2004. The Stretta Control Modules and Catheters accounted for
$481,000, or 32%, and $944,000, or 63%, respectively, of the Stretta System product sales for the nine months ended September 30, 2005, compared to $870,000, or 41%, and $1,159,000, or 55%, respectively, for the same period in 2004. The Secca
Control Modules and Handpieces accounted for $387,000, or 32%, and $757,000, or 63%, respectively, of the Secca System product sales for the nine months ended September 30, 2005, compared to $168,000, or 33%, and $326,000, or 63%, respectively,
for the same period in 2004. International sales accounted for $424,000 in the nine months ended September 30, 2005, compared to $57,000 in the same period of 2004.



Cost of goods sold



Our costs of goods sold represent the cost of producing generators and disposable devices. Cost of goods sold was $842,000 or 113% of product sales revenue in the quarter
ended September 30, 2005, compared to $1,036,000 or 120% of product sales revenue for the same period in 2004. For the nine months ended September 30, 2005, cost of goods sold was $2,837,000 or 103% of product sales revenue compared to
$3,168,000 or 117% of product sales revenue for the same period in 2004.



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Research and development expenses



Research and development expenses consist primarily of personnel costs, professional services, patent application and maintenance costs,
materials, supplies and equipment. Research and development expenses were $312,000 for the three months ended September 30, 2005, a decrease of $118,000 or 27% over research and development expenses of $430,000 for the three months ended
September 30, 2004. For the nine months ended September 30, 2005, research and development expenses were $906,000, a decrease of $454,000 or 33% over research and development expenses of $1,360,000 for the same period in 2004. The decrease
in spending for the three and nine months ended September 30, 2005 compared to the same periods of 2004 was due primarily to the reduced headcount in our research and development department as we implemented cost reduction measures in September
2004.



Clinical and regulatory expenses



Clinical and regulatory expenses consist primarily of expenses associated with the costs of
clinical trials, clinical support personnel, the collection and analysis of the results of these trials, and the costs of submission of the results to regulatory agencies. Clinical and regulatory expenses were $212,000 for the three months ended
September 30, 2005, a decrease of $10,000 or 5% over clinical and regulatory expenses of $222,000 for the three months ended September 30, 2004. For the nine months ended September 30, 2005, clinical and regulatory expenses were $
732,000, a decrease of $125,000 or 15% over clinical and regulatory expenses of $857,000 for the same period in 2004. Reduced clinical trial activity was the main reason of reduction of expenses.



Sales and marketing expenses



Sales and marketing expenses consist of personnel related costs, advertising, public
relations and attendance at selected medical conferences. Sales and marketing expenses for the three months ended September 30, 2005 were $1,608,000, a decrease of $228,000 or 12% over sales and marketing expenses of $1,836,000 for the three
months ended September 30, 2004. For the nine months ended September 30, 2005, sales and marketing expenses were $5,902,000, a decrease of $12,000 or 0.2% over sales and marketing expenses of $5,914,000 for the same period in 2004.



General and administrative expenses



General and administrative expenses consist primarily of the cost of corporate operations
and personnel, legal, accounting and other general operating expenses of our company. General and administrative expenses for the three months ended September 30, 2005 were $898,000, a decrease of $1,111,000 or 55% over general and
administrative expenses of $2,009,000 for the three months ended September 30, 2004. For the nine months ended September 30, 2005, general and administrative expenses were $2,766,000, a decrease of $1,256,000 or 31% over general and
administrative expenses of $4,022,000 for the same period in 2004. This decrease in general and administrative expenses for the three and nine months ended September 30, 2005 compared to the same periods of 2004 was primarily due to the cost
associated with the Audit Committee investigations amounting to $1,100,000.



Interest Income, net



During the quarter ended
September 30, 2005, compared to the quarter ended September 30, 2004, net interest income increased by $32,000. For the nine months ended September 30, 2005 and 2004, net interest income was $112,000, due to a decrease in the
nine-month total average cash and investment balance of approximately $3.8 million and an increase in investment yields from approximately 1.3% to 3.6%. Interest expense was not material for any period presented.



Decrease in warrant obligation



Our sale of 18,445,078 newly issued shares on April 8 and June 3, 2005 included
warrants to purchase an additional 2,481,298 and 6,741,241 respectively, shares of common stock to investors and warrants to purchase 553,352 shares of common stock to our placement agent. Similar to our February 2004 warrants, these warrants
provide for cash redemption by the holders upon the occurrence of certain events outside our control. As a result, the aggregate fair value of the warrants of $1.4 and $3.3 million, respectively, determined using the Black-Scholes model, was
recorded as a liability on the issuance dates with subsequent changes to the fair value of the warrants being recorded as a non-operating item through the statement of operations.



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The following table shows the changes to the fair value of the warrant obligations recorded as a non-operating (income)
expense through the statement of operations for the three and nine months ended September 30, 2005 and 2004:



|                    |  |                                          |        |   |                                         |   |      |      |  |   |        |   |  |   |        |  
|------------------- |  | ---------------------------------------- | ------ | - | --------------------------------------- | - | ---- | ---- |  | - | ------ | - |  | - | ------ | -
|                    |  | For the Three Months Ended September 30, |        |   | For the Nine Months Ended September 30, |  
|Warrant issue dates |  | 2005                                     |        |   | 2004                                    |   |      | 2005 |  |   | 2004   |  
|June 3, 2005        |  | $                                        | (1,678 | ) |                                         | $ |     |      |  | $ | (1,582 | ) |  | $ |       |  
|April 8, 2005       |  |                                          | (614   | ) |                                         |   |     |      |  |   | (803   | ) |  |   |       |  
|February 6, 2004    |  |                                          | (59    | ) |                                         |   | (297 | )    |  |   | (457   | ) |  |   | (1,419 | )
|                    |  |                                          |        |   |                                         |   |      |      |  |   |        |   |  |   |        |  
|                    |  | $                                        | (2,351 | ) |                                         | $ | (297 | )    |  | $ | (2,842 | ) |  | $ | (1,419 | )
|                    |  |                                          |        |   |                                         |   |      |      |  |   |        |   |  |   |        |  



LIQUIDITY AND CAPITAL RESOURCES



We have been financing our operations primarily through our cash and cash
equivalents, revenues, marketable securities, and financing activities. We have incurred net losses since inception and expect to continue to do so for the next several years.



As of September 30, 2005, we had cash and cash equivalents on hand of $6.5 million and working capital of $7.5 million. We intend to
finance our operations primarily through cash and cash equivalents, marketable securities, future financing and future revenues.



We have sustained operating losses and negative cash flows from operations and expect such losses to continue in the foreseeable future. We have been financing our
operations primarily through our cash and cash equivalents, revenues, marketable securities, and financing activities. We intend to finance our operations primarily through our cash and cash equivalents, marketable securities, future financing and
future revenues. Based on our current expectations of sales and operating costs, we anticipate that we will be unable to maintain our currently planned operations through 2006. If future revenues are less than expected or if operating costs are
greater than expected we will consume our capital resources significantly sooner than we expect. We are pursuing a number of alternatives to maximize stockholder value, including strategic transactions, collaborative partnerships and the licensing
or sale of certain of our intellectual property. Licensing or collaborative arrangements, if necessary to raise additional funds, may require us to relinquish rights to certain or all of our products or technologies. Any additional financing may not
be available in amounts or on terms acceptable to us, if at all. If we are unable to raise additional financial resources, we may be unable to continue as a going concern.



Net cash used in operating activities during the nine months ended September 30, 2005 was $10.5 million, resulting primarily from the
net loss for the period of $7.4 million, increased by the $2.8 million non-cash gain resulting from the decrease in warrant liability, and increase in inventories offset by net decrease in accounts receivable, prepaid and other current assets and
accrued liabilities. For the nine months ended September 30, 2004, net cash used in operating activities was $12.5 million, resulting primarily from the net loss for the period of $11.1 million, increased by the $1.4 million non-cash gain
resulting from the decrease in warrant liability, $1.25 million payment to settle legal liability reserve and increases in prepaid and other current assets, inventories and accrued liabilities partially offset by decrease in accounts receivable.



For the nine months ended September 30, 2005, net cash provided by
investing activities was $0.8 million consisting primarily of net proceeds from purchases and maturities of marketable securities used to fund operations. As of September 30, 2005, we had no material commitments for capital expenditures. For
the nine months ended September 30, 2004, net cash used in investing activities was $3.2 million, which consisted primarily of net purchases and maturities of marketable securities, as we invested the cash received from our private placement
financings in February 2004, partially offset by $0.4 million of property and equipment acquisitions.



Cash provided by financing activities was $11.2 million in the nine months ended September 30, 2005, related to the private placement of common stock and common stock warrants to a group of institutional
investors in the net amount of $11.0 million, in addition to $0.1 million from exercise of stock options and the Employee Stock Purchase Plan, and net cash provided by financing of business insurance in the amount of $0.2 million. For the same
period in 2004, cash provided by financing activities was $13.1 million, related to the private placement of common stock and warrants to a group of institutional investors in the net amount of $12.6 million, in addition to $0.2 million from
exercise of stock options and the Employee Stock Purchase Plan, and net cash provided by financing of business insurance in the amount of $0.2 million.



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Contractual Obligations



The following table sets forth our contractual obligations at September 30, 2005 and the years in which such obligations are expected to be settled.



|                                 |  |      |     |      |   |      |  |       |    |  |   |    
|-------------------------------- |  | ---- | --- | ---- | - | ---- |  | ----- | -- |  | - | ---
|                                 |  | 2005 |     | 2006 |   | 2007 |  | Total
|Future minimum lease commitments |  | $    | 101 |      | $ | 338  |  | $     | 13 |  | $ | 452
|Inventory purchase commitments   |  |      | 399 |      |   |     |  |       |   |  |   | 399
|                                 |  |      |     |      |   |      |  |       |    |  |   |    
|                                 |  | $    | 500 |      | $ | 338  |  | $     | 13 |  | $ | 851
|                                 |  |      |     |      |   |      |  |       |    |  |   |    



In August 2002, we announced that our
Board of Directors had authorized a stock repurchase program permitting the purchase of up to 1,000,000 shares of our Common Stock in open market transactions at prices deemed appropriate by management, and administered pursuant to Rule 10b-18 of
the Securities Exchange Act of 1934. Shares have not been repurchased under this plan since 2002.



Recent Accounting Pronouncements



In
November 2004, the FASB issued SFAS No. 151, Inventory Costs. SFAS 151 amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight,
handling costs and spoilage. This statement requires that these items be expensed as incurred and not included in overhead. In addition, SFAS 151 requires that allocation of fixed production overhead to conversion costs should be based on normal
capacity of the production facilities. This Statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 is not expected to have a material impact on our financial
position and results of operations.



In December 2004, the FASB issued
Statement No. 123(R) (SFAS 123(R)), Share-Based Payment. This statement replaces Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123(R) will require compensation costs related to share-based payment transactions to be recognized in the financial statements (with limited exceptions).
The amount of compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. This
statement is effective as of the beginning of the annual reporting period that begins after June 15, 2005. We are currently in the process of evaluating the impact from this standard on our results of operations and financial position.



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections (SFAS 154). This statement, which replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, requires that a voluntary change in
accounting principle be applied retrospectively to all prior period financial statements presented, unless it is impracticable to do so. SFAS 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be
accounted for as a change in estimate effected by a change in accounting principle, and also provides that correction of errors in previously issued financial statements should be termed a restatement. SFAS 154 is effective for fiscal
years beginning December 15, 2005. We anticipate that the adoption of SFAS 154 will not have a material impact on our financial statements.



Factors That May Affect Future Results



We have recently undergone a restructuring, which could adversely impact our business.



In order to reduce our operating costs, we have recently implemented a restructuring initiative primarily to implement the outsourcing of
our disposable component manufacturing. This resulted in a significant reduction in employee headcount from 71 to 33. We entered into a contract for the outsourced manufacturing with Life Science Outsourcing. These actions significantly change our
operations and could have adverse results, including:



| |  |  | Potential customers may choose not to purchase our products due to concerns over the stability of our organization;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | We may encounter difficulties in retaining key employees; and
| | - |  | -------------------------------------------------------------



| |  |  | The reduction of our operating costs may not achieve the goal of producing materially stronger financial results then we have historically experienced.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



We have outsourced the manufacturing of our disposable products to a single contract
manufacturer, and if that manufacturer is unable or unwilling to produce our product requirements in quality and quantity to our satisfaction, our business will be harmed.



We now rely on a single contract manufacturer to manufacture our disposable products. We have no prior history with this supplier and cannot
predict how well they will perform in meeting our quality and quantity requirements. We believe that this shift away from



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direct manufacturing will reduce our operating expenses, but unforeseeable difficulties in the outsourced manufacturing
could negatively impact operating expense reduction expectations. Our reliance on this single contract manufacturer subjects us to a number of risks outside of our control that could impact our ability to meet demand for our disposable products and
harm our business, including:



| |  |  | Inability of our contract manufacturer to manufacture the product at the quality and quantity levels we require;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | Delays or interruption of production due to production problems; and
| | - |  | --------------------------------------------------------------------



| |  |  | Unanticipated delays in delivery by our contract manufacturer due to changes in demand from us or their other customers.
| | - |  | ------------------------------------------------------------------------------------------------------------------------



We have yet to identify an alternate contract manufacturer to manufacture our disposable
products. Identifying and qualifying additional or replacement contract manufacturers, if required, may not be accomplished quickly or at all and could involve significant additional costs. Any interruption from our existing contract manufacturer
would limit our ability to manufacture our disposable products and could therefore have a material adverse effect on our business, financial condition and results of operations.



During 2006, we may have to raise additional funds to continue operations as currently conducted, or sell the Company. The terms of
either transaction may not be favorable to our stockholders.



We believe
that unless revenues increase and operating costs are controlled, our existing capital resources will not enable us to maintain current and planned operations through 2006. We may have to raise additional funds through the issuance of equity or debt
securities, or a combination thereof, in the public or private markets in order to continue operations, or sell the company. Additional financing and merger opportunities may not be available, or if available, may not be on favorable terms. The
availability of financing or merger opportunities will depend, in part, on market conditions, which have been depressed as of late. Any future equity financing could result in substantial dilution to our stockholders. If we raise additional funds by
issuing debt, we may be subject to limitations on our operations, through debt covenants or other restrictions. If adequate and acceptable financing is not available, we may have to delay development or commercialization of certain of our products
or license to third parties the rights to commercialize certain of our products or technologies that we would otherwise seek to commercialize. We may also reduce our marketing, customer support or other resources devoted to our products. Any of
these options could reduce our sales growth and result in continued net losses.



We may never achieve or maintain significant revenues or profitability.



We have incurred losses every year since we began operations. In particular, we incurred net losses of $15.3 million in 2004, $15.6 million in 2003, and $15.4 million in 2002 and $7.4 million for the nine months ended
September 30, 2005. As of September 30, 2005, we had an accumulated deficit of approximately $102.0 million. Our revenues are, and will be, derived from the sale of radiofrequency generators and our disposable devices, such as the Stretta
Catheter and Secca Handpiece. We have generated limited revenues, and it is possible that we will never generate significant revenues from product sales. Even if we do achieve significant revenues from our product sales, we expect to incur
significant net losses over the next several years and these losses may increase. It is possible that we will never achieve profitable operations.



If health care providers are not adequately reimbursed for the procedures which use our products, or for the products themselves, we may never achieve significant
revenues.



Our physician customers continue to encounter difficulties in
readily obtaining adequate reimbursement for the Stretta procedure on a case-by-case basis, and this continues to impact our ability to market and sell the Stretta System.



While the American Medical Association has issued a Level I CPT code for the Stretta procedure effective January 1, 2005, there is no
assurance that the established level of coverage will encourage physicians to perform the Stretta procedure or that local Medicare or private payers will choose to pay for this procedure. We have in the past received unfavorable Medicare coverage
determinations. Physicians, hospitals and other health care providers are unlikely to purchase our products if they are not adequately reimbursed for the Stretta procedure or the products. Some payers may refuse adequate reimbursement even though
significant peer-reviewed data has been published. If users of our products cannot obtain sufficient reimbursement from health care payers for the Stretta or Secca procedures or the Stretta or Secca Systems disposables, then it is unlikely
that our products will ever achieve increased market acceptance.



Reimbursement from third-party health care payers is uncertain due to factors beyond our control and changes in third-party health care payers policies could adversely affect our sales growth.



Even if third-party payers provide adequate reimbursement for our procedures or products,
adverse changes in third-party payers



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policies toward reimbursement could preclude market acceptance for our products and have a material adverse effect on our
sales and revenue growth. We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payers.



For example, some health care payers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person.
We cannot assure you that in a prospective payment system, which is used in many managed care systems, the cost of our products will be incorporated into the overall payment for the procedure or that there will be adequate reimbursement for our
products separate from reimbursement for the procedure.



Internationally,
market acceptance of our products is dependent upon the availability of adequate reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and
include both government-sponsored health care and private insurance. Although we are seeking international reimbursement approvals, we cannot assure you that any such approvals will be obtained in a timely manner or at all. If foreign third-party
payers do not adequately reimburse providers for the Stretta procedure and the products used with it, then our sales and revenue growth may be limited.



We may be delisted from the Nasdaq SmallCap Market if we fail to timely file our periodic reports. This may adversely affect trading in our stock and our ability to
raise capital.



Due to our inability to timely file our Form 10-Q for the
quarter ended June 30, 2004, we became subject to delisting from the Nasdaq SmallCap Market. Subsequent to an appeal proceeding, the Nasdaq Listing Qualifications Panel determined to continue our listing on the Nasdaq SmallCap Market,
conditioned upon the timely filing of all periodic reports with the Securities and Exchange Commission and Nasdaq for all reporting periods beginning with September 30, 2004 and ending on September 30, 2005. Should we fail to make any
filing in accordance with this condition, we will not be entitled to a new hearing with Nasdaq and our securities may be immediately delisted from the Nasdaq SmallCap Market.



There are no assurances that we will timely make our filings in accordance with the terms of Nasdaqs conditional continued listing
determination. If we are delisted, trading in our common stock could be subject to the so-called penny stock rules that impose additional sales practice and market making requirements on broker-dealers who sell and/or make a market in
those securities. Consequently, removal from the Nasdaq SmallCap Market, if it were to occur, could affect the ability or willingness of broker-dealers to sell and/or make a market on our common stock and the ability of purchasers of our common
stock to sell their securities in the secondary market. These rules could further limit the market liquidity of our common stock and the ability of investors to sell our common stock in the secondary market. If we are delisted from the Nasdaq
SmallCap Market, our stock price is likely to decline significantly.



We are
not in compliance with the minimum bid price requirement of the Nasdaq SmallCap Market. We may consequently be delisted in the near future. This may adversely affect trading in our stock and our ability to raise capital.



We have failed to comply with the minimum $1.00 per share bid price requirement for
continued listing on the Nasdaq SmallCap Market. Consequently, on or about November 14, 2005, the Nasdaq staff will either grant an additional 180 calendar day compliance period if it determines that we meet the initial listing criteria of the
Nasdaq SmallCap Market except for the minimum bid price requirement, or it will provide notification that our stock will be delisted. Either event may result in substantial volatility in the trading of our stock.



If we receive an additional compliance period, we may be required to implement a reverse
stock split. Our stockholders have authorized up to a 1-for-4 reverse stock split on our stock. While we have no immediate plans to implement a reverse stock split, we may be required to do so in the future to remain listed on the Nasdaq SmallCap
Market. Should we implement a reverse stock split, the number of our shares being traded will be reduced and volatility in the trading of our stock may increase. Further, there are no assurances that a reverse stock split will ensure compliance with
the minimum bid price requirement. There are also no assurances that our stock price after a reverse stock split will be above $1.00 per share at all (which would be the case if, prior to the split, our stock price is below $0.25 per share), nor
that it will maintain a $1.00 per share price for at least ten consecutive trading days  the requirement to remedy the minimum bid price deficiency.



If we receive a notice of delisting, we may appeal the decision but there are no assurances that we will be successful in remaining listed. If we are ultimately delisted,
trading in our common stock could be subject to the so-called penny stock rules that impose additional sales practice and market making requirements on broker-dealers who sell and/or make a market in those securities. Consequently,
removal from the Nasdaq SmallCap Market, if it were to occur, could affect the ability or willingness of broker-dealers



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to sell and/or make a market on our common stock and the ability of purchasers of our common stock to sell their
securities in the secondary market. These rules could further limit the market liquidity of our common stock and the ability of investors to sell our common stock in the secondary market. If we are delisted from the Nasdaq SmallCap Market, our stock
price is likely to decline significantly.



If physicians do not adopt our
products, we will not achieve future sales growth.



To achieve increasing
sales, our products must continue to gain recognition and adoption by physicians who treat gastrointestinal disorders. Our products represent a significant departure from conventional treatment methods. We believe that physicians will not increase
rates of adoption of our systems unless they determine, based on published peer-reviewed journal articles, long-term clinical data and their professional experience, that our systems provide effective and attractive alternatives to conventional
means of treatment. Some physicians may be slow to adopt new products and treatment practices, partly because of perceived liability risks and uncertainty of third-party reimbursement. As procedural technique plays a significant role in achieving
positive results from the Stretta and Secca Procedures, improper use of either system may have unsatisfactory patient outcomes or cause adverse events, leading to physician dissatisfaction, negative publicity, or lawsuits. Additionally, some of our
customers and potential customers may find the time necessary to perform a Stretta procedure to be a limiting issue, as their endoscopy unit schedule is typically dominated by short diagnostic procedures. Future adverse events or recalls could also
impact future acceptance rates. If we cannot achieve increasing physician adoption rates of our products, we may never achieve significant revenues or profitability.



Our internal controls may not be sufficient to ensure timely and reliable financial information.



In October 2004, we restated our financial results for the quarter ended March 31, 2004
to reflect adjustments to our previously reported financial information. The restatements arose, in part, out of an internal investigation by the Audit Committee. As a result of the investigation, management and the Audit Committee determined that
certain sales employees had improperly offered rights of return and exchange in violation of our revenue recognition policy, and a manufacturers representative had not actually made sales that it had reported to the Company. As a result of
this investigation, we were also unable to timely file the Form 10-Q for the quarter ended June 30, 2004. In connection with the restatement of our financial results for the quarter ended March 31, 2004, our independent registered public
accounting firm identified material weaknesses in our internal controls and procedures.



Our Audit Committee, with the assistance of independent legal and accounting advisors, evaluated the effectiveness of our disclosure controls and procedures. As a result of this evaluation, our Board of Directors has directed management to
implement and management has implemented additional measures designed to ensure that information required to be disclosed in our periodic reports is recorded, processed, summarized and reported accurately. These measures include the adoption of a
Disclosure Committee Charter, the adoption of a written revenue recognition policy, further controls on shipment of products for revenue transactions, and additional training of our sales and marketing staff to minimize the risk of revenue
recognition errors. The effectiveness of our controls and procedures remain limited by a variety of factors including:



| |  | Faulty human judgment and simple errors, omissions or mistakes;
|- |  | ---------------------------------------------------------------



| |  | Fraudulent action of an individual or collusion of two or more people;
|- |  | ----------------------------------------------------------------------



| |  | Inappropriate management override of procedures; and
|- |  | ----------------------------------------------------



| |  | The possibility that our enhanced controls and procedures may still not be adequate to assure timely and accurate financial information.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------



If we fail to have effective internal control over financial reporting in place, we could be
unable to provide timely and accurate financial information and be subject to delisting from Nasdaq, and civil or criminal sanctions.



We face competition from more established GERD treatments and from competitors with greater resources, which will make it difficult for us to achieve significant
market penetration.



Companies that have well-established products,
reputations and resources dominate the market for the treatment of GERD. Our primary competitors are large medical device manufacturers that manufacture instrumentation for anti-reflux surgery and C.R. Bard, and NDO Surgical, each of which
manufactures an endoscopic sewing device for treating GERD. Other competitive devices may be developed.



Some of these competitors are larger companies that enjoy several competitive advantages over us, which may include:



| |  |  | Existing anti-reflux surgical procedures and devices for the treatment of GERD;
| | - |  | -------------------------------------------------------------------------------



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| |  |  | Established reputations within the surgical and gastroenterological community;
| | - |  | ------------------------------------------------------------------------------



| |  |  | Established distribution networks that permit these companies to introduce new products and have such products accepted by the physician community promptly;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Established relationships with health care providers and payers that can be used to facilitate reimbursement for new treatments; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Greater resources for product development and sales and marketing.
| | - |  | ------------------------------------------------------------------



We do not feel that we compete with large pharmaceutical companies, such as AstraZeneca, Takeda Abbott Pharmaceutical, Wyeth Laboratories and Eisai, because candidate
patients for Stretta are intolerant to drug therapy or have failed, or only partially responded to, drug therapy. However, these companies have an established relationship with the gastroenterology community and generate over $12 billion in annual
U.S. revenues from the proton pump inhibitor drug class. We could be adversely affected if one or more pharmaceutical companies elects to market aggressively against our product, or if a new, more effective, pharmaceutical product is developed.



We have limited sales and marketing resources, and failure to manage our
sales force or to market and distribute our products effectively will hurt our revenues.



We have limited sales and marketing resources. Currently we rely on a limited number of direct sales representatives for the sale of our products in the United States. We also deploy an indirect sales channel of a
limited number of manufacturers representatives firms who we use to cover, in general, less populated areas of the United States. The success of this channel will depend upon a number of factors, many of which are beyond our control. These factors
include, but are not limited to, the willingness of such representatives to prioritize the sale of our products and their effectiveness in such sales efforts.



There are significant risks involved in building and managing our sales force and marketing our products, including our:



| |  |  | Inability to gain market acceptance of our products and technology;
| | - |  | -------------------------------------------------------------------



| |  |  | Inability to hire a sufficient number of qualified sales people with the skills and understanding to sell the Stretta and Secca Systems effectively;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Failure to adequately train our sales force in the use and benefits of our products, making them less effective promoters; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | Failure to accurately price our products as attractive alternatives to conventional treatments.
| | - |  | -----------------------------------------------------------------------------------------------



Our failure to adequately address these risks will harm our ability to sell our products.



Internationally, we rely on third-party distributors to sell our products, and we cannot
assure you that these distributors will commit the necessary resources to effectively market and sell our products.



Internationally, we rely on a network of distributors to sell our products and we will need to attract additional distributors to grow our business and expand the
territories into which we sell our products. Distributors may not commit the necessary resources to market and sell our products to the level of our expectations. If current or future distributors do not perform adequately, we may not realize
expected international revenue growth.



We depend on suppliers who provide
materials and components used in our products, and if we lose our relationship with any individual supplier, we may face regulatory requirements with regard to replacement suppliers that could delay the manufacture of our products.



Third-party suppliers provide materials and components used in our products, some of
which are the single or sole source for the components they provide. If any of our suppliers become unwilling or unable to supply us with our requirements, replacement or alternative sources might not be readily obtainable due to regulatory
requirements applicable to our manufacturing operations. Obtaining components from a new supplier may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product
sales. This process may take a substantial period of time, and we cannot assure you that we would be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would reduce our product sales and revenue.



If we, or our suppliers, fail to comply with the FDA Quality System
Regulation, manufacturing operations could be delayed and our business could be harmed.



Our manufacturing processes are required to comply with the Quality System Regulation, or QSR, which covers the methods and



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documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of our
products. The FDA enforces the QSR through inspections. Our first QSR inspection was in March 2001, and we were also inspected in July 2003. There were no significant findings from either inspection. If we fail any future QSR inspections, our
operations could be disrupted and our manufacturing delayed. Failure to take appropriate corrective action in response to a QSR inspection could force a shut-down of our manufacturing operations, a recall of our products, and potentially a
revocation of the FDA 510(k) clearance of our products, which would have a material adverse effect on our product sales, revenues, expected revenues and profitability. Furthermore, we cannot assure you that our key component suppliers are, or will
continue to be, in compliance with applicable regulatory requirements, will not encounter any manufacturing difficulties, or will be able to maintain compliance with regulatory requirements. Any such event could have a material adverse effect on our
available inventory and product sales.



Our failure to obtain or maintain
necessary FDA clearances or approvals could hurt our ability to commercially distribute and market our products in the United States.



Our products are medical devices and are therefore subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an
exemption applies, each new Class II or III medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. Either process can be lengthy and expensive. The FDAs 510(k)
clearance process usually takes from four to twelve months, but may take longer. The premarket application, or PMA, approval process is much more costly, lengthy and uncertain. It generally takes from one to three years or even longer. Delays in
obtaining regulatory clearance or approval will adversely affect our ability to generate revenues and profitability from new products. We cannot assure you that the FDA will ever grant 510(k) clearance or premarket approval for any new product we
propose to market. If the FDA withdraws or refuses to grant approvals, we will be unable to market such products in the United States.



If we market our products for uses that the FDA has not approved, we could be subject to FDA enforcement action.



Our Stretta and Secca Systems are cleared by the FDA, the Stretta System for the treatment
of GERD and the Secca System for the treatment of bowel incontinence in patients who have failed more conservative therapies such as diet modification and biofeedback. FDA regulations prohibit us from promoting or advertising either system, or any
future cleared or approved devices, for uses not within the scope of our clearances or approvals. These determinations can be subjective, and the FDA may disagree with our promotional claims. If the FDA requires us to revise our promotional claims
or takes enforcement action against us based upon our labeling and promotional materials, our sales could be delayed, our profitability could be harmed and we could be required to pay significant fines or penalties.



Modifications to our marketed devices may require new 510(k) clearances or PMA approvals
or require us to cease marketing or recall the modified devices until such clearances are obtained.



Any modification to an FDA 510(k)-cleared device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new FDA 510(k) clearance or,
possibly, PMA approval. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can review any such decision. We have modified aspects of our products, but we believe that new 510(k) clearances are not
required. We may modify future products after they have received clearance or approval, and, in appropriate circumstances, we may determine that new clearance or approval is unnecessary. Though we believe these changes fall within the acceptable
scope of changes allowed for Class II devices, we cannot assure you that the FDA would agree with any of our decisions not to seek new clearance or approval. If the FDA requires us to seek 510(k) clearance or PMA approval for any modification to a
previously cleared product, we also may be required to cease marketing or recall the modified device until we obtain such clearance or approval. Also, in such circumstances, we may be subject to significant regulatory fines or penalties.



We face risks related to our international operations, including the need to obtain
necessary foreign regulatory approvals.



To date we have international
distribution agreements for countries in Europe, Asia, Africa, and Central America. We have obtained regulatory clearance to market the Stretta System in the European Union, Australia and Canada and to market the Secca System in the European Union.
Marketing our products in additional countries may require regulatory approvals. We cannot assure you that we will be able to obtain or maintain such approvals. Furthermore, although contracts already signed with international distributors specify
payment in U.S. dollars, future international sales may be made in currencies other than the U.S. dollar. As a result, currency fluctuations may impact the demand for our products in countries where the U.S. dollar has increased compared to the
local currency. Engaging in international business involves the following additional risks:



| |  |  | Export restrictions, tariff and trade regulations, and foreign tax laws;
| | - |  | ------------------------------------------------------------------------



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| |  |  | Customs duties, export quotas or other trade restrictions;
| | - |  | ----------------------------------------------------------



| |  |  | Economic or political instability;
| | - |  | ----------------------------------



| |  |  | Shipping delays; and
| | - |  | --------------------



| |  |  | Longer payment cycles.
| | - |  | ----------------------



In addition, contracts may be difficult to enforce and receivables difficult to collect through a foreign countrys legal system, and the protection of intellectual property in foreign countries may be more
difficult to enforce. Any of these factors could cause our international sales to decline, which would impact our expected sales and growth rates.



Product liability suits against us may result in expensive and time-consuming litigation, payment of substantial damages and an increase in our insurance rates.



The development, manufacture and sale of medical products involves a
significant risk of product liability claims. The use of any of our products may expose us to liability claims, which could divert managements attention from our core business, could be expensive to defend, and could result in substantial
damage awards against us. For example, we have been party to product liability lawsuits in which there were allegations that our products were defectively designed and that we were negligent in our manufacturing.



We maintain product liability insurance at coverage levels we believe to be commercially
acceptable, and we re-evaluate annually whether we need to obtain additional product liability insurance. However there can be no assurance that product liability or other claims will not exceed such insurance coverage limits or that such insurance
will continue to be available on the same or substantially similar terms, or at all. Any product liabilities claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing any
coverage in the future.



We have limited protection for our intellectual
property. If our intellectual property does not sufficiently protect our products, third parties will be able to compete against us more directly and more effectively.



We rely on patent, copyright, trade secret and trademark laws to protect our products, including our Stretta Catheter, our Secca Handpiece
and our Curon Control Module, from being duplicated by competitors. However, these laws afford only limited protection. Our patent applications and the notices of allowance we have received may not issue as patents or, if issued, may not issue in a
form that will be advantageous to us. Patents we have obtained and may obtain in the future may be challenged, invalidated or legally circumvented by third parties. We may not be able to prevent the unauthorized disclosure or use of our technical
knowledge or other trade secrets by consultants, vendors, former employees or current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions. Furthermore, the laws of foreign countries may
not protect our intellectual property rights to the same extent as the laws of the United States. If our intellectual property rights do not adequately protect our commercial products, our competitors could develop new products or enhance existing
products to compete more directly and effectively with us and harm our product sales and market position.



Because, in the United States, patent applications are secret unless and until issued as patents, or corresponding applications are published in other countries, and because publication of discoveries in the
scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first to file patent applications for such inventions. Litigation or regulatory proceedings, which could result in substantial cost and
uncertainty, may also be necessary to enforce patent or other intellectual property rights or to determine the scope and validity of other parties proprietary rights. There can be no assurance that we will have the financial resources to
defend our patents from infringement or claims of invalidity.



Because of
our reliance on unique technology to develop and manufacture innovative products, we depend on our ability to operate without infringing or misappropriating the proprietary rights of others.



There is a substantial amount of litigation over patent and other intellectual property
rights in the medical device industry. Because we rely on unique technology to develop and manufacture innovative products, we are especially sensitive to the risk of infringing intellectual property rights. While we attempt to ensure that our
products do not infringe other parties patents and proprietary rights, our competitors may assert that our products and the methods they employ may be covered by patents held by them or invented by them before they were invented by us.
Although we may seek to obtain a license or other agreement under a third partys intellectual property rights to bring an end to certain claims or actions asserted against us, we may not be able to obtain such an agreement on reasonable terms
or at all. If we were not successful in obtaining a license or redesigning our products, our product sales and profitability could suffer, and we could be subject to litigation and potentially substantial damage awards.



Also, one or more of our products may now be infringing inadvertently on existing patents. As
the number of competitors in our



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markets grows, the possibility of a patent infringement claim against us increases. Whether a product infringes a patent
involves complex legal and factual issues, the determination of which is often uncertain. Infringement and other intellectual property claims, with or without merit, can be expensive and time-consuming to litigate and divert managements
attention from our core business. If we lose in this kind of litigation, a court could require us to pay substantial damages or grant royalties, and prohibit us from using technologies essential to our products. This kind of litigation is expensive
to all parties and consumes large amounts of managements time and attention. In addition, because patent applications can take many years to issue, there may be applications now pending of which we are unaware and which may later result in
issued patents that our products may infringe.



If we lose our rights to
intellectual property that we have licensed we may be forced to develop new technology and we may not be able to develop that technology or may experience delays in manufacturing as a result.



Our license with Gyrus Group PLC, a public company incorporated and existing under the laws
of England and Wales, allows us to manufacture and sell our products using their radiofrequency generator technology. In addition, the University of Kansas license allows us to apply radiofrequency energy to tissue. To the extent these license
interests become jeopardized through termination or material breach of the license agreements, our operations may be harmed. We may have to develop new technology or license other technology. We cannot provide any assurance that we will be able to
develop such technology or that other technology will be available for license. Even if such technology is available, we may experience delays in our manufacturing as we transition to a different technology.



If we are unable to attract and retain qualified personnel, we will be unable to expand
our business.



We believe our future success will depend upon our ability
to successfully manage our employees, which includes attracting and retaining engineers and other highly skilled personnel. Our employees are at-will employees and are not subject to employment contracts. The loss of services of one or more key
employees could materially adversely affect our growth. Failure to attract and retain personnel, particularly management and technical personnel, would materially harm our ability to grow our business rapidly and effectively.



Our directors, executive officers and principal stockholders have significant voting power
and may take actions that may not be in the best interests of our other stockholders.



Our officers, directors and principal stockholders holding more than 5% of our common stock together control over 50% of our outstanding common stock. As a result, these stockholders, if they act together, will be
able to control the management and affairs of our company and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of
delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.



Our stockholder rights plan, certificate of incorporation, bylaws and Delaware law contain
provisions that could discourage a takeover.



In November 2001, we adopted
a stockholder rights plan. The purpose of the plan is to assure fair value in the event of a future unsolicited business combination or similar transaction involving Curon. If an individual or entity accumulates 15% of our stock, or 20% in the case
of certain existing stockholders, the rights become exercisable for additional shares of our common stock or, if followed by a merger or other business combination where Curon does not survive, additional shares of the acquirers common stock.
The intent of these rights is to force a potential acquirer to negotiate with the Board to increase the consideration paid for our stock. The existence of this plan, however, may deter a potential acquirer, which could negatively impact shareholder
value.



In addition, our basic corporate documents and Delaware law contain
provisions that might enable our management to resist a takeover. Any of the above provisions might discourage, delay or prevent a change in the control of our company or a change in our management. The existence of these provisions could adversely
affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.



Item 3. Quantitative and Qualitative Disclosures of Market Risk



We invest our excess cash primarily in U.S. government securities and marketable debt securities of financial institutions and corporations with strong credit ratings. These instruments have maturities of eighteen
months or less when acquired, with an average maturity date of at least six months. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any
material fashion. Accordingly, we believe that while the instruments



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we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any
material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments.



Item 4. Controls and Procedures



(a) Evaluation of disclosure controls and procedures.



We
maintain disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act), that are designed to ensure that information required to be
disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is
accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and
procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met.
Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure
controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.



Our management, with the participation of our Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and
Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective.



(b) Changes in internal control over financial reporting.



There were no changes in our internal control over financial reporting during the quarter ended September 30, 2005, that have
materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



PART II OTHER INFORMATION



Item 1. Legal Proceedings



In April 2003, a
civil action was filed against us in United States District Court for the Northern District of California by Federal Insurance Corporation, our insurance carrier, for rescission, reformation, and restitution in connection with the our liability
insurance policy. This litigation was settled during the quarter ended September 30, 2005 for approximately $50,000, a partial return to us of our insurance premiums.



ITEM 6. Exhibits



(a)
Exhibits.



|            |  |                                                                                                                                                  
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                      
|31.1        |  | Chief Executive Officers Certification Pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|            | 
|31.2        |  | Chief Financial Officers Certification Pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|            | 
|32.1        |  | Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 
|            | 
|32.2        |  | Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 



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CURON MEDICAL, INC.



SIGNATURES



Pursuant to the requirements of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                        |  |                                  |  |                                                                                                                                  
|----------------------- |  | -------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------
|                        |  | CURON MEDICAL, INC. (Registrant)
|                        |  |                                 
|Date: November 10, 2005 |  | By:                              |  | /s/ LARRY C. HEATON II                                                                                                           
|                        |  |                                  |  | Larry C. Heaton II President and Chief Executive Officer (Principal Executive Officer)                                           
|                        |  |                                 
|                        |  | By:                              |  | /s/ ALISTAIR F. MCLAREN                                                                                                          
|                        |  |                                  |  | Alistair F. McLaren Vice President of Finance Chief Financial Officer and Chief Information Officer (Principal
Financial Officer)



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